Permanently topped up swamp

The US stock market has proved remarkably resilient in the face of everything that has been thrown at it in the last two years or more. Photo: Bloomberg

Irving Fisher, the Yale economist, is supposed to have said, “Stock prices have reached what looks like a permanently high plateau”, shortly before the crash of 1929 began. In a similar vein, in his second-quarter newsletter this year, Jeremy Grantham, veteran fund manager, wrote, “If we expect a market crash, we should also expect to have a crash in margins (as we did in 2008-09) or a truly dramatic rise in sustained inflation (as we did in 1979-81) or some powerful combination. All of which is possible of course, but I think improbable, at least in the near term.” Does it mean that a fate similar to that of Fisher awaits Jeremy Grantham? Perhaps. But his arguments are compelling.

The US stock market has proved remarkably resilient in the face of everything that has been thrown at it in the last two years or more. Grantham concludes that investors neither discount the future correctly nor do they seem to learn much from history. Investors overweight the present. In the present, three things dominate. All three contribute to the expansion of profit margin or sustaining high margin and expansion of price-to-earnings (PE) multiples. The three factors are the monetary policy of the Federal Reserve, an ageing population profile, and the rising political and monopoly power of corporations. In other words, Grantham is predicting that the “neo-liberal” political and economic agenda of the last two-three decades looks set to continue without too many changes. They have done their job in boosting revenue and profit share of gross domestic product by 30% and expanded PE multiples by 70% in the last 20 years in the US, and these factors look set to continue. Hence the quote above.

It is somewhat depressing to contemplate the possibility that these are unlikely to change quickly, for these factors have created big sociopolitical fault lines. They have boosted worker insecurity, worsened income and wealth inequality and widened the social and economic divide between the top 1% and the rest 99% in America. The opioid crisis—the rapid increase in the use of prescription and non-prescription opioid drugs—and the decline in the male labour force participation rate in America are manifestations of these fault lines that the neo-liberal economic agenda has generated.

In a paper titled The Deep Causes Of Secular Stagnation And The Rise Of Populism, published in March, James Montier and Philip Pilkington had included monopoly power and increasing returns to shareholders as two elements of the “neo-liberalism” that has defined capitalism in America and in many other Western nations in recent times. Low real investment and low labour share of income are the other notable ones.

How did things reach this pass? Clearly, one can write expansively about the grand economic and political churn that happened in the late 1970s due to a combination of economic stagnation, high inflation and high unemployment as the successful post-World War II economic model collapsed. That heralded the arrival of a new strain of capitalism which Montier and Pilkington label “neo-liberalism”. The proximate question, however, is how companies managed to generate high revenue and sustain high profit margins in the face of low (official) inflation rates and without undertaking much real investment.

Òscar Jordá, Moritz Schularick and Alan M. Taylor show us the way. In their paper The Great Mortgaging, published in 2014, they note that in the 1980s, the Bank for International Settlements (BIS) decreed that mortgage loans secured by residential properties would only attract half the risk weight of loans to companies. As a result, banks made more mortgage loans than commercial loans. The ratio of real estate lending to total lending by banks spiked to over 50% in the new millennium, from around 40% in the 1980s. Companies responded by cutting back on real investments. But the growth of public markets should have helped mitigate the problem of reduced availability of bank loans. It did not.

Agency theory that sought to align the interests of managers with that of shareholders solved the problem by making them owners too. Or so they thought. But share prices became an end in themselves, not just for managers but also for the Federal Reserve that assigned an important role for asset prices in sustaining economic activity. As Grantham says, the Federal Reserve lent a helping hand in bad times in financial markets and let good times run, creating a moral hazard. So public companies underinvested. Share buyback was more profitable. Returns to real investing were uncertain and suffered from time inconsistency. John Asker and co-authors have documented (Corporate Investment And Stock Market Listing: A Puzzle?, October 2014) that private companies invest more in the business than listed companies. Their investment decisions are around four times more responsive to changes in investment opportunities than those of public firms.

As anti-trust and monopoly regulations were whittled down, corporations acquired political and economic power. Globalization ensured that work travelled, if not workers. As a result, wage growth began to crawl. Despite a partial retreat of globalization, technological developments overcompensate to keep worker insecurity elevated. Restrained wage growth is more likely than not. Officially, inflation rates will stay low. Janet Yellen may be reappointed. The swamp is in no danger of being drained. Society can take care of itself or be damned. Stocks will keep flying. Dow 36,000 beckons.